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Tuesday, 2 June 2009

Capitalism Evolving: Be a Cockroach, Not a Dinosaur

Not Dying, Adapting

Many of the world’s most ardent free market economists would have us believe that the current wave of government intervention in markets heralds the end of capitalism. It’s not, because capitalism isn’t something you can kill, it simply adapts itself to the prevailing reality and carries on, regardless of economists and their ideas.

The proper metaphor for capitalism is evolution – which is ironic because Adam Smith’s invisible hand was one of the inspirations for Charles Darwin’s intellectual breakthrough, the theory of natural selection – a rare case of science imitating economics. Evolution, the process of life adapting to the complex changes in the natural world, is mimicked by capitalism, the process of markets adapting to complex changes in the financial world.

Lo’s Adaptive Market Hypothesis

With a nod and a wink to the Efficient Market Hypothesis Andrew Lo has labelled his alternative to it the Adaptive Market Hypothesis. Modelled on evolutionary processes Lo reasons that the way in which complexity emerges through natural selection and mutation is analogous to the emergence of complexity in markets. In the natural world if the conditions change – due to global warming, deforestation, volcanic activity, asteroid strikes or something – then the natural order adapts. The species best fitted to survive in the new reality will win and those unlucky enough to be out-evolved will lose.

Something similar seems to happen with stockmarkets. If instead of animal species we consider types of investor and instead of meteor strikes we think of the collapse of the banking industry you have the idea. Now we’re seeing the equivalent of human inspired global warming as governments desperately intervene to flood the markets with cheap money, nationalise banks and abrogate the legal rights of bondholders.

Cyclically Adjusted P/E Ratios

We can see the changes in the stockmarket ecosystem over time by looking at historical cyclically adjusted P/E ratios (CAPE). The idea was originally used by Ben Graham who proposed that the proper basis for assessing the profitability of any company was over an extended period of history not the arbitrary time unit of a single year. This idea has been taken up by Robert Schiller whose ten year running CAPE analysis of the US markets shows that the long-term P/E ratio is around 15 – a number which the markets had been running in excess of until collapsing earlier this year (see the spreadsheet here - look at the second sheet, labelled Figure 1.3).

Examining Schiller’s figures it’s quite obvious that CAPE can vary significantly over time, for considerable periods – it’s not a constant number but one that trends about the average value in what looks like a suspiciously mean regressing way. It’s easy to imagine that this variation in CAPE equates to the different environments within which investors are operating at various times.

Underlying this is the horrible truism that when markets tank due to worsening economic conditions they do so in a perfectly nasty way. P/E ratios establish a new, lower level because investor expectations about future growth drop. In a real downturn this isn’t just about share prices dropping – it’s about falling earnings. If earnings and P/E ratios are both falling then, obviously, share prices will drop by more than earnings. P/E ratios can then remain depressed for long periods of times, even while earnings recover, as scalded investors stay clear.

Changing Markets, Static Investors

This points up that there’s no single way of investing that will succeed under all conditions. As the environment changes so must the investor if they’re to survive. Trouble is that most investors can’t do this quickly enough to avoid getting caught in the wave of destruction that’s occasioned by most economic natural disasters. Worse, people become fixated on expecting the return of the world they’ve become accustomed to.

In the wake of the dotcom collapse millions of investors threw good money after bad by buying into worthless companies because they expected them to regain their previous, illusory highs. This is a general psychological trend, not something specific to investors. So Russian émigrés who fled Russia in the wake of the communist revolution spent their entire lives expecting to return home, post-war British politicians couldn’t understand that the Empire was finished and a generation of economists are struggling to make their mental models fit with an old reality they’ve never personally experienced.

Time and again generations of investors get rendered extinct by failing to recognise that market conditions have changed. These changes aren’t permanent, but they can last for significant periods only to be replaced by something completely different again. A single investing lifetime isn’t long enough to encompass all possible conditions.

The New Reality

The past decade has been one of extremes in stockmarkets, reflecting changes in the world around us. A new global order is emerging, shakily, and it’ll take time for us all to adjust. Most investors have been wrong-footed at some point in this process and there’s little reason to suppose that the changes are over yet. Despite this investors need to try and find a way of making money, to avoid being wiped out no matter how many asteroids strike.

Governments are now throwing money around like confetti rather than letting the free markets take their natural course. Banks have been propped up instead of allowing them to die in much the same way that humans try to stop species becoming extinct. Partly this is out of a sense of moral duty and partly it’s due to fear that allowing the death of one will cause a chain reaction. For investors this is part of the new natural environment: capitalism can’t be killed by governments, it will mutate to deal with the new order and we’ve got to work with it.

Be a Cockroach Investor

Most people are unable to adapt at the macroeconomic level to the evolutionary changes in the markets: human psychology isn’t fluid enough to cope with the dynamics of such moves. We need to develop cockroach-like strategies that will see us survive under all circumstances while recognising that those lucky animals that simply happen to hit on the right strategy will massively outperform us. There are millions of people out there playing the markets in more or less random fashion – at any one time a few of them will get rich by being in the right place at the right time. We then call them gurus but remember; genius always strikes twice.

Still, the generational changes in cyclically adjusted P/E suggest that it may be possible to finesse a straightforward index tracking or value investing strategy by coupling it with a careful use of derivatives. Providing you’ve the liquidity to support it then going short when the markets are high, as judged by CAPE, and gearing up to go long when the markets are low would be rational. For private investors using the right combination of ETF’s can get you close to this, but it’d be easier if someone would launch a single vehicle to do it for us.

In the end to avoid being out-evolved you either need to be lucky enough to be a dinosaur during one of the long periods of unchanging market conditions – 1949 to 1969, for instance – or you need to be a cockroach, well adapted to surviving under any circumstances. Just don’t think you’re an indestructible insect when you’re actually a lumbering giant lizard with a brain in your bottom.


Related Articles: Darwin’s Stockmarkets, Contrarianism, Fundamental Indexing Can’t Save You From Aliens

3 comments:

  1. i'm kind of interested to know the effect of etfs on the whole investing/speculating market. i'm thinking of the vast pot the bullion funds have amassed, but also just the standard ftse trackers... they're meant to reduce risk, but surely only if their strategy isn't too good and they don't get too big. i mean: what happens if a ftse-beating etf is developed? or is that an oxymoron..

    the masterpiece etf you wish for in the last-but-1 paragraph would surely increase volatility. if everybody registered the higher-than-average performance of tracker funds, bought into an etf, and then got on with their other interests, you have a kind of de facto bubble ...? therefore cancelling the advantages ...?

    probably i just don't know how these products work...

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  2. How do you know what you are: cockroach or lizard?

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  3. X ... ETFs can either directly track their target or can use synthetic means – e.g. derivatives. This can involve counterparty risk such as the problems some of the ETC funds had with AIG last year. There’s also some evidence that some large ETF’s can affect their target indices so this isn’t just a theoretical concern. In the extreme case where everyone used index trackers then the market would break down but that won’t happen because someone would decide to break ranks and capitalise on stupid valuations by either shorting or taking individual companies off-market. That’s capitalism for you.

    Rob ... The idea was that if your survival depends on market conditions remaining the same forever then you’re a big, dumb lizard while if your investment strategy will work regardless of changes in the environment then you’re an indestructible roach. Arguably there’s a third type of investor – the chameleon, which can change investment strategies rapidly to cope with changing conditions. As far as I know the chameleon is entirely mythical existing only in the minds of deluded individuals and bulletin board posters :-)

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